Food Maker Showdown: Brand Names vs. Private Labels

In the realm of defensive investing strategies, my Foolish colleagues have pointed out that everyone has to eat. And when it comes to stocks of food makers, you've likely considered one of two basic approaches: (1) go with blue-chip companies that make premium-priced brand-name products, many of which also pay a nice dividend, or (2) take a chance on smaller, lesser-known companies that compete in the value segment, either via their own brands or through private label goods sold to food retailers.

Before we peel back the lid on a can o' analysis, let's compare how these approaches performed over the past year.

Although all four stocks bested the S&P 500's one-year return of (40.8%), you clearly would have done better with the private-label producers, even after the dividends paid by household names Kraft and General Mills. So, what exactly is behind this divergence? Grab some pretzels -- premium or store brand -- and read on!

A tale of two shopping listsLooking back over the past year or so, the trade-down effect has been more than a talking point for analysts and commentators. According to an industry spokesperson, U.S. sales of private-label food rose 10% in 2008 while branded products squeaked out a sales gain of 2.8%. In other words, tight purse strings have inspired shoppers to bid bye-bye to Betty Crocker while welcoming the likes of Target's (NYSE: TGT) Archer Farms brand.

That trend should remain intact for the duration of the recession, and may even persist beyond it. If consumers find little quality and flavor difference in value-priced products, there is no rule saying that they will return to former brands once the economy picks up. This is just my opinion, but I don't see cereal and salad dressing tapping into consumers' personal identities as strongly as personal care products or apparel.

Given that view, it is easy to envision consumers running back out to the mall to celebrate the return of a reliable paycheck, but it is difficult to imagine a shopping cart mash-up as the newly solvent masses rush the Oscar Mayer section of the deli aisle.

Retailers bite backThe fact that commodity costs skyrocketed in 2008 is a well-worn story, and if you purchased groceries anytime in the past year, you know that some of those costs have been passed along to the consumer. However, food makers are not necessarily far ahead of the game now that raw ingredients such as soybeans, wheat, and other "inputs" have moderated in price. For example, reporting results for the quarter ended in November 2008, General Mills cited a 25% rise in input costs over the prior four years against price increases that "ranged from 8% to 10%."

Food retailers, apparently, could not care less. Costco (NYSE: COST) management has been quoted as saying that they are prepared to cease stocking national brands that do not yield on price. The president of Safeway (NYSE: SWY) took an even more aggressive posture: Speaking of food makers who refuse to lower prices, he warned, "We're going to chew them up on corporate brands."

Mashed potatoes or meatballs?You can cover a lot of ground by chucking a meatball, but mashed potatoes have that oh-so satisfying splatter effect. Just as the schoolkid in me would have a hard time deciding on his weapon of choice, the adult investor is very much on the fence about which type of food maker represents the most profitable play going forward.

So far, the private-label impact on brand-name market share appears fairly contained. Kraft, for example, reported that private-label presence in its food categories increased 1% for 2008. That said, if the aggressive talk coming from food retailers translates into equally aggressive action, the situation could quickly grow more severe.

My proposed course of action? Diversify. Over the very long term, the blue-chip names should be able to adapt to whatever new sales environment may now be emerging. However, holding shares of a private label/value brand company -- or a food retailer that benefits from consumer trade-down habits -- could help offset medium-term pain as blue-chip companies reposition brand names. Moreover, because bargain hunters are alive and well in just about any economic environment, I don't see the value segment of the market as unduly threatened by an economic recovery.

At the end of the day, people will continue to eat, but investors should ask the question, whatwill they eat?

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